Should We Have Seen It Coming?

This was a time when, of course, the reverberations were being felt about coming problems. Housing was going down the drain, and there were lots of problems that everybody understood were coming in one way or another. How did you see him as being able to play a role, someone that would be able to change things in a way that you thought would be much more positive than what was happening?

Yeah. I think you need to be careful. Having been through what we've been through it's easy to say, "Oh, we all knew what was coming our way." And we really didn't. I mean, there were certainly troubles -- we'd seen the big boom in house prices. We'd seen some uneasiness there in the fall of 2007, when we started to have the subprime crisis.

But in truth, for much of that period, the bigger issues seemed to be longer-run. If you think about it, candidate Obama, Sen. Obama was running on sort of long-run economic issues, like restoring prosperity to the middle class, dealing with the perennial problem of health care in the United States. He talked a lot about the budget deficit, about the need to transition to clean energy. Those are not dealing with an immediate crisis. They were about our long-run economic security and strength.

But it was -- I think where you really started to see his ability to deal with what's going to turn out to be the crisis was more during, actually, the actual campaign. So the primary's over. It's the fall of 2008. And I think we probably all remember maybe it was the first debate with [candidate Sen. John] McCain [R-Ariz.], where there was this on again/off again. It was shortly after the collapse of Lehman [Brothers], and the whole question of "Maybe we shouldn't be debating; we should be going and getting into Congress or something."

And I remember, I think it was Sen. Obama who said, "Really, a president has to be able to do many things at once, and we can debate and also get back to Washington and vote on anything that needs to be voted on." He obviously seemed like a cool head in the middle of a crisis and was already seeming like someone who could handle anything that was going to come our way.

... What was it that you were seeing in 2007 that gave you the idea that there was an opportunity here, that there was going to be a collapse?

It was a lot of the models had a series of assumptions, and the most critical assumption with which we disagreed was they were trying to figure out what would be the annual rate of household appreciation. HPA, they were calling it: household price appreciation.

We thought you can't build a model on the theory that housing prices are always going to go up. That's not a rational model. And it's particularly not a rational model when you have now introduced much more leverage, because these are high loan-to-value ratio loans.

You had Fannie and Freddie, while they themselves felt they were only committing 70 percent or 80 percent loan-to-value, they were in fact writing 90 percent and 95 percent and even 100 percent in buying private sector mortgage insurance. But the primary risk was theirs.

They were in effect reinsuring with the PMI companies. We felt that that was clearly inflating the price of houses to have both subprime and normal loans be based on more or less 100 percent loan-to-value, whereas in the old days, people thought about 70 percent, 75 percent loan-to-value. Introducing the leverage had to mean more people were buying more expensive houses.

... What's his reaction? So you're on the telephone saying: "I've got a buddy here who has got some problems going on in Europe right now. I've been seeing stuff back at the office. I've got to warn you here." What's his reaction to this?

I think his reaction, one, he was thinking about what I was saying. He asked a few questions about the leverage and the size of the losses. And remember, UBS was 50 times levered at that point, but we weren't alone. All the firms were 35 to 55 times levered at that point, and everyone had different -- how they marked their positions was different. But let's just say if a company is levered and X percent of their book, 15 percent of their book is Level 3 assets, then you have a big part of your position that you just can't figure out how to mark.

And so I think it was not an awakening. I mean, this guy, the president was very savvy on business issues, so he asked the right questions right away. We talked about leverage, and we talked about pricing, and we talked about the losses and things like that. But I think for both him and I [sic], it was a moment that was a bit of a wow moment, because the truth is that soon thereafter the unraveling began. And we were talking about this possibility happening for probably 30 days before the Lehman crisis took hold.

So take us to then August. So things are getting worse. The housing market, everybody is realizing, is a problem that's not going to go away. Take us to what you were doing, where you were going, what was going on, and the conversations that sort of sent up all the red flags for you.

So all of a sudden July comes, and you get defaults in housing at a standard deviation versus the norm. Usually it was very small defaults, and all of a sudden you had it five, 10 times of what normal was. And recall at that time you had subprime, you had prime, you had all different types of housing finance going on. And then, like I said, UBS was looking at their own positions and started seeing that we had our own problems. And I think a lot of firms were starting to have problems where, you know, our goal as an industry is to be in the moving business, not in the warehouse business, and when things get less liquid, all of a sudden you get in the warehouse business. And so our position started to get more aged. And then the first week in August has kind of been a fun weekend. That's my wife's birthday, and a few days later it's Obama's birthday, so we exchange calls, so on and so forth. And he called my wife -- it was Aug. 1 -- for her birthday.

And then my wife and I were going on my friend's boat, who is a good friend of mine, worked at a hedge fund. And we started talking, and he was having his problems at the hedge fund on funding and on pricing, and at the same time I saw the bigger firms starting to have some problems, housing was starting to creak a little, and I just started to say to myself, "If I'm seeing this right, we're going to have some mass disruptions coming." And it just felt that way.

And I called the president that morning for his birthday, and jokingly: "Hey, happy birthday, Barack. Thanks for calling my wife."

I'm going to jump ahead and jump all over the place just to make sure we cover everything. ... You're sort of renowned for seeing troubles maybe before some others saw them, or at least understanding it a bit more than others. I want you to talk a little bit about what you saw, why you sort of saw troubles coming ahead. And then there's the famous memo that you wrote to other folks at UBS [Investment Bank] after coming back from dropping your son off at camp that July. Talk a little bit about what you saw and what you wrote down in this memo, why you wrote that memo.

It's interesting. So for most of my career until '04 I was always in sales and trading on the fixed-income side, so I was really a trader almost my entire career, and then 2004 at UBS I became chief operating officer, and then I eventually became president in late '07 when we were going through the real tough times at the firm and on the Street. But in mid-07 I was at a few different risk meetings for the firm, and I haven't been that close to the risk for a few years, and our leverage was very high; leverage at other institutions [was] getting high; people were talking about these Level 3 assets that I really never heard that much about before, which is things that you can't price on your balance sheet.

And I kind of felt like, OK, since the days I was trading, our goal was to be a boutique on steroids, be very nimble, be quick, be large, and do what you do well, but don't be everything to everyone everywhere. And then the Wall Street firms started getting much bigger and became -- they were on 100 exchanges, and they were in 50-plus countries, and the big firms did it with balance sheet and leverage. And it kind of felt to me like we were getting to this situation where I felt that firms were overlevered. We had a great 10-year run with growth, and it just felt to me that I had this gut feeling like things were going too well.

And then all of a sudden you started to hear the housing market start creaking a little, and it felt like there was going to be a real game change on the street. And then at UBS we mark to market; we have different accounting than the other competitors. We don't use gap accounting; we use IFRS [International Financial Reporting Standards] accounting, and we were one of the first shops that were going to show a billion-dollar loss. Well, a billion-dollar loss in sales and trading is pretty big, and that's an understatement.

And then you felt like things started getting stale. Positions started getting stale; you started to see liquidity dry up a little. And at that point -- we're in a business about liquidity. That is really our lifeline, funding ourselves and liquidity, and once you start seeing liquidity dry up and once you start seeing losses starting to come in larger numbers than you've heard before, there was a little nervousness.

So really, my view was I felt like things were starting to slow up. Most people felt like growth was going fast. Everyone had a view that the Fed was going to continue to stay neutral or hike rates. And for me, I felt like I disagree. I think we're going to get in a slowdown. I kind of think you're going to see the Fed start turning the other way. We really didn't have inflation. And so I kind of had a different view, and that's kind of culminated to kind of what's become a fun story to talk about the day of his birthday.

You had attended meetings prior to the crisis in which you had alerted regulators. Tell me about that.

Well, as I said earlier, we were going around the room and talking about what's happening, what's going on. And they would specifically ask all the time about residential real estate and the increase in prices and so on. And I said the subprime mortgage business was using exotic instruments, no-doc, low-doc, option ARMs. Stated income [loans] was an invitation -- originated by brokers; 70 percent were outside brokers -- it was an open invitation for fraud, and it's toxic waste. As you know, I tend to talk in English.

And someone else on the other side would say: "We don't see any issues here. We went through this before." I say, "The reason you don't see any issues is because home prices are going up, and as soon as that stops --" And there was disagreement.

What was on Bear Stearns' books that was scaring [Tim] Geithner and Bernanke?

Well, I would say that unfortunately none of it scared them until the market seized up with lack of liquidity. I wish it would have scared them -- (laughs) -- and it would have stopped it.

But it was scaring somebody. The market, the investors were scared, pulling their money out. Therefore there was a liquidity problem.

Yeah, but that's my point. It wasn't until the liquidity occurred that it appeared that the regulators got on this.

So you think Geithner and Bernanke were pretty clueless about what was happening over at Bear?

You'd have to ask them. I would say this: The primary regulator of Bear Stearns is the SEC [Securities and Exchange Commission]. Geithner was head of the New York Federal Reserve, and Bernanke was the chairman. So it's not that they couldn't have known or shouldn't have known. The one that should have known what was going on and totally failed was the SEC.

Did you know what was on their books?

Yes.

You knew that they were holding a lot of these complex financial instruments, CDOs [collateralized debt obligations], synthetic CDOs?

And Countrywide is there. And [Countrywide CEO Angelo] Mozilo was there. Other bankers are there from Citigroup. What happened?

Well, oftentimes what would happen at these meetings is the regulators would be there, like Chairman [of the Fed Ben] Bernanke and the head of OCC [Office of the Comptroller of the Currency], as a guest. And they would often go around the room and say: "Well, what are you guys seeing out there? What's working? Are you concerned about housing?," trying to get input. And there might be, I don't know, 30 or 40 people in the room, 30 or 40 bankers, CEOs actually of banks and financial institutions.

Like yourself.

Exactly. And we would just go around the room. And when they came to me, I would say: "This is toxic waste. We're building a bubble. We're not going to like the outcome. I'm very concerned." And some other people would either say nothing or they might say: "We don't see that concern. These things are performing fine. And we think option ARMs [adjustable rate mortgages] and negative amortization ARMs and low-doc and no-doc mortgages are OK."

I don't know. All's I can say is they missed the financial crisis. This has been happening for generations. And I believe what you have to work with is that regulators will miss financial problems. We have to make financial institution failure bearable, possible and tolerable. Because they have failed in the past, they will fail in the future, and no amount of regulation can make up for ineffective regulators.

So I just say we've got to have a process that assumes that the regulators are going to fail and financial institutions are going to fail. And how do we make sure that that failure is manageable, that it doesn't turn into systemic risk and a massive recession and so forth? I believe there are ways to do that, but we're going to have to change our process, and we're going to have to admit that regulators are not capable, with all the regulations you want to put on, are still not capable of keeping financial institutions from failing.

The crisis of 2008. You've said that this was different than other economic crises that we've faced. Why?

It shouldn't have happened. Most of our financial crises in the past [are] due to some macroeconomic event – an oil disruption, war, the Depression. And we can go into the causes of that. But this was caused by a few institutions, about 20, who, in my opinion, lost all credibility relative to managing their risk. They were very highly leveraged. They did not have a good liquidity program. And quite frankly, it even got into greed and, I think, malfeasance.

And it then, because of what they did -- and again, I have no sympathy for what they did. It was management incompetence, and it should never have happened. Unfortunately, our safety valves didn't work, and this thing blew up to a worldwide impact. And the sad thing is it should never have happened. The management should have stopped it before it got big, and the safety valves should have worked so it didn't get as big as it did.

And that's the sad part about this crisis, because of its devastation on consumers all over the United States and all the developed world. And people are suffering for something that should never have happened.

The reason I'm interested in this is because this is what people that are marching down there with Occupy Wall Street will bring up all the time. These banks are getting away with fines, getting a slap on the wrist, $300 million here, $400 million there. It doesn't amount to anything for them, and we're never allowed to take these things through the courts and figure out what really happened.

Well, that could be fair. And if what we really want is a Truth and Reconciliation Committee a la South Africa, that's a social objective. It's not a regulatory or a market objective. If that's what as a country we want to do, I'd be up for that.

I think the Occupy Wall Street tribe might be a little bit disappointed by the outcome of that, but I could be wrong. ...

What's your bet?

My bet is that if an objective process was gone through, it would be very hard to pin guilt for all this bad stuff that happened on any one party, but rather you'd find that pretty much everybody that was involved in the process contributed to it, of course including bankers. Bankers contributed to it substantially.

I feel like I contributed to it substantially for a number of reasons. One is that there was stuff going on that I didn't ring an alarm bell on, and I was as aware as anybody of what was going on. ... I didn't understand everything that was going on. In fact I missed some pretty big things in terms of the risk that was building up on banks' balance sheets.

But we saw product that we thought was probably being mis-sold. We saw risk that we thought was misunderstood by investors and where we reached that conclusion ourselves. It's not to say we had no lapses, because of course we did in our 30,000-person organization. But we treated those lapses very seriously, and we had quite a bureaucratic process, as it were, to screen those things out.

But when I saw what I believed to be other firms that were behaving in an irresponsible manner, I didn't ring alarm bells. I didn't come and speak to you on a documentary about the terrible things that are going wrong in our world, and I feel responsible for that today.

... If you had to do it over again, what would you do differently?

... I think I would have had more strength in my own convictions about what was really going on, and not only acted on it to defend my own firm but taken a bolder or broader stand in public and in private.

So you would have blown the whistle on other banks?

A bad practice, yeah. I can make all sorts of excuses for my own behavior, but the reason that I didn't blow the whistle was that I didn't have a high level of confidence that I was right. ...

They want to look at the master contracts for the derivatives. And you guys find e-mails that define what? What is the fear of asking for those contracts?

The fear is the mere asking [for] those contracts will set off panic and will set off panic that there is a view that Lehman is in trouble, which of course people in the marketplace know. And it is really quite telling, because what's striking about it is, here we are a month out from the deluge, the implosion, and we don't even have, as a country, in our regulators and our policy-makers the basic knowledge that they need about how our financial system operates.

You know, there had been a dramatic transformation of the financial system from the 1980s…

How prepared were our Treasury and the Fed -- [then-Treasury Secretary Hank] Paulson, [Chairman of the Federal Reserve Ben] Bernanke, [then-President of the Federal Reserve Bank of New York Tim] Geithner in New York -- before this crisis? What did you guys find?

Woefully unprepared. I think that was for me one of the biggest revelations of the year-and-a-half investigation that we undertook. What became clear as you look at the record is the extent to which the people who were charged with overseeing our financial system really didn't have a sense of the risks that were embedded in that system that could collapse our financial system and, ultimately, our economy.

And there's instance after instance where the folks who were in charge, who were charged with protecting the public, are caught completely by surprise. Of course, in 2007, in the spring and summer of 2007, Hank Paulson and Ben Bernanke reassure the public consistently that there is really no chance that the problems in the subprime market will spill over into the larger economy. And of course that turned out to be wholly wrong.

A good example is in July of 2007, when one of the first real signals of trouble to come happens, and that is the hedge funds that are run by Bear Stearns blow up. And then there is a meeting at the Fed about the implications of that. And what you read when you see what happened in that meeting is the view is that Bear Stearns is relatively unique, when, in fact, now we know that the holdings of major investment firms in these toxic subprime securities was pervasive.

You see that it's only in August of 2008 the Treasury claims that it fully understands the depth of the problems at Fannie Mae and Freddie Mac, literally weeks before the government decides to seize those entities. It is only a month before Lehman collapses that the New York Federal Reserve, the Federal Reserve Board of New York, decides that it had better look into the derivatives positions of Lehman Brothers, who had 900,000 derivatives contracts, and only one month before they said, "We'd better get a handle on this."

And of course then they're afraid to ask for the information from Lehman, lest they set off panic in the marketplace.

Phil, let's start with the meltdown and the causes. What did you guys find to be the basic causes of the meltdown?

Well, at the heart of this crisis were really the twin factors of recklessness on Wall Street -- unbridled, reckless actions -- coupled with abject regulatory neglect in Washington, this brew of a private, financial sector run amok without the kind of guardians of the public interest on the watch, protecting our economy, protecting our financial system. And I think when you look at what happened, what's most striking is the extent to which this was an avoidable crisis.

You know, there has been a whole school of rhetoric coming out of this crisis that it was the perfect storm, that this could not have been anticipated, that there were such large forces that collided that no human being could have foreseen the magnitude of what happened to our financial system and to our country. But when you look at the facts, what you will see is you will see a building over 30 years of a deregulatory mind-set in which the belief became embedded in intellectual circles and the financial circles that the financial masters on Wall Street had learned to control risk, that there was an intersection of their interest in self-preservation with the protection of the public interest, and there was a real belief in the light hand of regulation.

But in the early 2000s you see the emergence of lots of warning signs, red flags, flashing red and yellow lights along the way: the unsustainable rise in housing prices; the reports of egregious and predatory lending practices that were cropping up all over this country, starting in places like Cleveland and then spreading to the "sand states" [Arizona, California, Florida and Nevada].

What you see is, as early as 2004, the FBI is warning about an epidemic of mortgage fraud that, if left unchecked, could leave us with losses as big as the savings and loan crisis. You see the growing risk being taken by the big financial houses on Wall Street. Take, for example, Goldman Sachs. In 1997, I think they make about 39 percent or so, or in the high 30s of their revenue comes from what they call principal and trading, principal investment and trading.

By 2007 that has risen to about 79 percent, essentially making money just by trading on the marketplace. And of course you had that small matter of the doubling of mortgage debt in this country and the creation of $13 trillion of mortgage securities. All of that occurred as regulators either turned a blind eye or didn't have a real sense of the risks that were embedded in this system that had grown in the last two to three decades.

Yeah. We didn't have the superstar system at JPMorgan. We did not have that system when I was there, so I --

But you were, on the other hand, paid to seek out risk and insure it.

Yes, I was. But I was also responsible for explaining why that trade made sense to senior management, and if I couldn't explain that clearly, or if I couldn't articulate it, if I couldn't show numbers that made sense, if I couldn't work with a whole team of people and get them all to agree with me, then the trade didn't happen. ...

But in 2005, you go to a conference, a derivatives conference in Nice --

That's right.

-- and you made a statement there.

Yes. So I was chairing a panel of other exotic credit derivative traders, and I think I had a hedge fund guy there, maybe two hedge fund guys and some bank guys there. And 2005 -- at this point, I was overwhelmed with the interest in credit derivatives and in particular in structured credit derivatives. And what I saw was a huge wave of demand from the investor base ... in structured credit..., exotic credit derivative products. What I could see was a huge wave of demand. And the business I was in at the time was in training, and I was getting phone calls into our business all day long: "Can you come and tell us what these products are? We're investing."

In fact, I was getting phone calls, and this is what was really nerve-racking, I was getting phone calls from risk management departments of investors who were saying: "We've got a billion dollars of this stuff. Can you come and tell us what they are?"

And I remember thinking, why are you calling me now? Why didn't you call me before you made the decision to buy a billion dollars of this stuff? How can you, as a risk manager, hold your head up and say that you've done your job if you don't understand what these products are in the first place? Where were you when the decision was made?

And so I'm sitting there saying, "I think the world's gone a bit mad." And I look at the panel, and I turn to them, and I said, "Look, I think we've got some irrational exuberance going on in the credit department," to, you know, take a leaf from [former Fed Chair Alan] Greenspan's book.

And they all -- "Oh no, of course not. You know, of course we don't." But they weren't interested in saying that we had irrational exuberance in the credit markets because they were profiting from all of these investors who were interested in the product. And the next day, you know, the front page of the FT [Financial Times], "Terri Duhon says irrational exuberance in the credit markets." And I got phone calls from some of my clients saying: "What are you saying? How can you say something like that? You're going to scare our investors." And I said: "Hang on. I think your investors need to be thinking -- (laughs) -- spreads look really tight. What are we doing here? What's going on?" One, you know, do these prices really represent fair risk and credit right now? And two, do people really understand what they're investing in? I'm not so sure. In fact, I know they don't. And --